Analysis of Trade-Off and Pecking Order Theory on Company's Capital Structure

Topics: Finance, Corporate finance, Capital structure Pages: 8 (2603 words) Published: November 28, 2011
In many recent studies, it has a growing concern whether pecking order or trade-off theory can give better determination on firms’ “optimal” capital structure in different scenarios. In trade-off theory, it helps to determine the debt proportion and maintain optimal balance in order to maximise company’s market value. However, pecking order theory promotes that companies tend to issue debts when company has internal financial deficit or deviation from target capital leverage. Hence, it shows mixed evidences such as Shyman-Sunder and Myers (1999) found more supportive evidences for pecking order theory but Hovakimian, Opler and Titman (2001) examines that firms’ debt-equity issuance choice is significant for repurchase decision of debts compared to securities issues during target leverage deviation. Therefore, should company follow pecking order model in short-run and reversion of target leverage in long-run? Capital Structure

According to “classic” proposition of Modigliani and Miller (1958), they claim that firm’s value is independent of capital structure but market value affects firm’s debt and equity level and assume under perfect capital market condition, managers can ignore shareholders wealth and many considerations about capital structure decision since companies are financed irrelevant to its market value. However, it is criticised that imperfect market do actually exist, different source of external finance will affect managers’ investment decision and company’s value will affect capital structure, i.e. bankruptcy cost, agency cost, tax can affect firm’s optimal capital structure and market value maximisation (Warner 1977, Jensen and Meckling 1976).

Static Trade-off theory (Target Capital Theory)
According to (Baxter, 1967) trade-off models, firms will maintain optimal capital structure by balancing the cost and benefit of debt, i.e. tax shield and financial distress cost. Modigliani and Miller (1963) also extended their previous study that agency and bankruptcy cost of debt may outweigh tax benefit in reality and create “threshold of debt” concept, i.e. optimal capital structure should “trade-off” between the marginal benefits of debt issues relate to its cost. Tax advantage of debt

Under agency theoretical models (Jensen and Meckling, 1976), tax shield benefit can reduce the potential free cash flow problems and conflict between managers and shareholders can offset underinvestment and asset substitution problem. Besides, (Modigliani and Miller, 1963) also suggest that corporate tax treatment can allow firms to issue debts to reduce tax liability and increases after-tax cash flow but Taggart (2005) extend that company only has tax advantage when corporate tax rate exceed personal tax rate since it may affect investor to demand premiums to compensate net income reduction and issue debts negatively related to personal tax rate but positively related to corporate income rate for acquiring company’s securities (Graham, 2003). Free cash flow of agency cost

From Jensen and Meckling (1976), agency cost of managers and shareholders will be conflicted due to interest and information separation which managers will conduct costly actions to shareholders, i.e. rewarding unprofitable activities or overvalue investment requirements. Therefore, profitable firms will have more free cash flow to invest into less NPV projects but Jensen (1986) states that debt can reduce managers’ personal behaviour as debt’s obligation can force managers pay out cash and act as disciplining tool to monitor managers’ performance and improve investment decision by lowering free cash flow under managers’ control.

Criticism of Trade-off Theory
Agency cost of debt
According to Jensen and Meckling (1976), firms need to maximise shareholders’ wealth by investing into more risky projects from increasing dividends and investment available. However, when D/E ratio increases, managers may have greater incentive to undertake risky...
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